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Home , Wealth

JUN 06.17.2016

ECONOMICS: US PERSPECTIVES CYCLES: THE UNTOLD STORY

+ Joseph G. Carson, US Economist and Director—Global Economic Research, [email protected]

In the last 25 years, wealth cycles have become more dominant and volatile. Wealth creation has provided support and stimulus to the economy, while its destruction has triggered disruption, dislocation, uncertainty and eventually the end to economic cycles. Monetary policymakers should be aware of this fundamental shift between wealth and economic cycles, especially since the current wealth cycle appears to be extended—perhaps even overextended.

Wealth Creation and the Economic Cycle expansions of the 1990s and 2000s was 460% to 540% range that it had occupied Wealth creation is a natural part of every directly and indirectly triggered by abrupt for the prior 40 years (Display 1, next economic cycle. To be sure, every eco- and sharp wealth losses. page). nomic growth cycle sees an expansion of The Historical Record its real and financial . Existing Since the early 1990s, the main reason The Federal Reserve collects and pub- companies expand their physical footprint. wealth creation outstripped growth lishes data on household balance sheets, New companies get added to the fold. by such a wide margin was the faster aggregate wealth positions, and the Households play a key role as well in this growth in financial holdings, primarily composition of real and financial asset wealth-creation process: they acquire equities. Indeed, the average growth rate holdings. Based on published data, existing physical and financial with of financial asset holdings during that household wealth and income growth new borrowing and , and they build period was 150 basis points faster than more or less paralleled one another from and acquire assets with new investments. underlying income growth and 120 basis the 1950s to the early 1990s. During that points faster than real asset growth. No Although wealth and economic cycles are roughly 40-year time span, household doubt the dramatic fall in official and inextricably linked, there’s no rule that says income recorded an average annual gain of market interest rates played a role in cycles must parallel one another in terms 7.8% and wealth rose 7.7% annualized. financial asset inflation. of scale or duration. Nevertheless, there Real assets grew a tad faster than financial had been a long-standing symmetry assets, but both were within shouting Flows vs. Prices among wealth, economic and income distance of overall income growth. The Federal Reserve balance sheet data cycles—with the aggregate movements in allow us to separate out the wealth gains But over the past 25 years, the relationship each cycle more or less paralleling those that are attributable to new flows (or the of wealth and asset cycles to economic of the others. acquisitions of real and financial assets) and income cycles has fundamentally versus the wealth gain driven by price However, during the last 25 years, that changed. For example, since the start of appreciation. The results were very relationship has changed. Not only has the the early-1990s economic cycle, the surprising. wealth cycle become more powerful and average annual gain in household wealth dominant, but its reversal or destruction has increased 110 basis points above that Up until the early 1990s, the increase in has been sharper, deeper and extremely of household income growth. That has the market of household holdings of disruptive to general conditions. rocketed the ratio of household wealth to was driven 40% by new flows In our view, the demise of the economic income to 640%—quite a leap from the (or purchases) and 60% by price apprecia-

1 tion. That relationship flipped in the last 25 years, with 60% of the gain in household Display 1 holdings of real estate attributable to new Wealth Cycles Have Become More Dominant and Volatile flows and 40% to price appreciation. Household Net Worth as a Percent of Income

The factors contributing to financial wealth creation were also reversed. Up until the 680 1990s, most of the gain in financial asset 640 holdings was driven by new flows (55%) and less by price appreciation (45%). 600 However, in the past 25 years, 62% of the gain in financial asset holdings comes from 560 price appreciation and only 38% from new Percent 520 flows or acquisitions.

Speculative Periods 480 The financial flow data only enable us to 440 identify unusual patterns—what some 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 might call speculative periods, when asset values are driven mainly by price gains and Through March 31, 2016 Source: Haver Analytics and US Federal Reserve Board not by new flows or investments. For example, during the 1995–2000 equity boom, households actually withdrew $516 billion from their direct holdings of entirely, to the unconventional policies of In our view, the altered pattern reflects the and mutual funds. Nevertheless, the the Federal Reserve. The large asset fundamental shift in monetary policy market value of household of purchase programs the Fed conducted regimes from to price targeting. stocks and mutual funds ballooned—from have lifted its financial asset holdings from And the pitfall of price targeting is that it $5.7 trillion to $12.2 trillion—an indication $500 billion at the start of 2009 to over tends to ignore or overlook real and that increased values were all due to price $4.2 trillion today. financial asset inflation unless it has a speculation and not new savings flows. direct impact on the price basket policy- At this point in time, it would be hard to makers are targeting. A similarly speculative period occurred prove that the current state of affairs is during the mid-2000s in the form of a another financial bubble in the making. But In the end, it doesn’t matter if our analysis housing boom. Based on the financial flow clearly the pattern of gains on the origin of the changing pattern data, there was a $10 trillion increase in (i.e., driven mainly by price appreciation between wealth and economic and income the market value of household holdings of and not new flows) rivals what was seen in cycles is correct or not. What does matter real estate—from $14.9 trillion at the end the late 1990s. The only difference is that is that the wealth cycle has become more of 2001 to $24.9 trillion at the end of the new buyer and driver of financial asset dominant in the past 25 years. Yes, it 2006. The lion’s share of that increase, price gains isn’t sensitive to interest rates provides support and stimulus to the 70%, was due to price appreciation and or motivated by capital gains and losses. economic cycle. But when the wealth cycle only 30% came from new flows or goes south, it also triggers massive Risk Management and Monetary Policy acquisitions. disruption, uncertainty and major financial The three large wealth gains of the past losses that—in the 1990s and the Any Potential Current Imbalances? 25 years indicate that something has 2000s—triggered the end to the economic We began the current wealth cycle in fundamentally changed in the wealth and cycle. Policymakers would be well advised 2009, and since then, household stock income cycles. And, the cumulative gain of to recognize the fundamental shift in and mutual fund holdings have nearly the three cycles has increased household economic and wealth cycles and begin to doubled from $11.1 trillion to $20.6 wealth by $65.5 trillion. That’s an astound- adjust policy from the standpoint of risk trillion. Of that gain, only 6% can be ing amount by any measure, but it’s even management—focusing on avoiding the ascribed to new flows or purchases and more striking when one considers the fact boom–bust cycles of the past two the rest (94%) to price appreciation. that household wealth stood at $23 trillion decades. n when this process began. At first blush, this clearly looks unbalanced. But it can be attributed largely, if not

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